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Chapter Twelve: Arbitrage Pricing Theory

The document summarizes the Arbitrage Pricing Theory (APT), which is an equilibrium factor model of security returns. The APT states that no arbitrage opportunities can exist if security prices adjust until the expected return is a linear function of various macroeconomic factors. It provides examples showing how an arbitrage portfolio can be constructed to earn riskless profits by combining securities with offsetting exposures to factors like interest rates. The APT assumes markets are competitive, investors prefer more wealth, and the price-generating process follows a multi-factor model.

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65 views

Chapter Twelve: Arbitrage Pricing Theory

The document summarizes the Arbitrage Pricing Theory (APT), which is an equilibrium factor model of security returns. The APT states that no arbitrage opportunities can exist if security prices adjust until the expected return is a linear function of various macroeconomic factors. It provides examples showing how an arbitrage portfolio can be constructed to earn riskless profits by combining securities with offsetting exposures to factors like interest rates. The APT assumes markets are competitive, investors prefer more wealth, and the price-generating process follows a multi-factor model.

Uploaded by

JeremiahOmwoyo
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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CHAPTER TWELVE

ARBITRAGE PRICING
THEORY

1
Background

• Estimating expected return with the Asset


Pricing Models of Modern Finance
– CAPM
• Strong assumption - strong prediction

2
Market Index on Efficient Set Corresponding Security
Market Line

Expected Expected
B
Return Return
C
x x
x xx
Market x
x xx
Index x
x x
x
x xx
A x
x xx
x
x xx

Risk Market
(Return Variability) Beta
Market Index Inside Corresponding Security
Efficient Set Market Cloud

Expected Expected
Return Return

Market
Index

Risk Market Beta


(Return Variability)
FACTOR MODELS

• ARBITRAGE PRICING THEORY (APT)


– is an equilibrium factor model of security returns
– Principle of Arbitrage
• the earning of riskless profit by taking advantage of
differentiated pricing for the same physical asset or security
– Arbitrage Portfolio
• requires no additional investor funds
• no factor sensitivity
• has positive expected returns
– Example …
5
Curved Relationship Between Expected Return and Interest Rate Beta

Expected Return

35%

E F
D
25%

C
15%

B
A
5%

-3 -1 -5% 1 3
Interest Rate Beta

-15%
The Arbitrage Pricing Theory

• Two stocks
 A: E(r) = 4%; Interest-rate beta = -2.20
 B: E(r) = 26%; Interest-rate beta = 1.83
 Invest 54.54% in E and 45.46% in A
 Portfolio E(r) = .5454 * 26% + .4546 * 4% = 16%
 Portfolio beta = .5454 * 1.83 + .4546 * -2.20 = 0
 With many combinations like this, you can create
a risk-free portfolio with a 16% expected return.
The Arbitrage Pricing Theory

• Two different stocks


 C: E(r) = 15%; Interest-rate beta = -1.00
 D: E(r) = 25%; Interest-rate beta = 1.00
 Invest 50.00% in E and 50.00% in A
 Portfolio E(r) = .5000 * 25% + .4546 * 15% = 20%
 Portfolio beta = .5000 * 1.00 + .5000 * -1.00 = 0
 With many combinations like this, you can create a
risk-free portfolio with a 20% expected return. Then
sell-short the 16% and invest the proceeds in the
20% to arbitrage.
The Arbitrage Pricing Theory

• No-arbitrage condition for asset pricing


 If risk-return relationship is non-linear, you
can arbitrage.
 Attempts to arbitrage will force linearity in
relationship between risk and return.

9
APT Relationship Between Expected Return and Interest Rate Beta

Expected Return
35%
F
E
25% D

15%

C
5%

A B
-3 -1 -5% 1 3
Interest Rate Beta

-15%
FACTOR MODELS

• ARBITRAGE PRICING THEORY (APT)


– Three Major Assumptions:
• capital markets are perfectly competitive
• investors always prefer more to less wealth
• price-generating process is a K factor model

11
FACTOR MODELS
• MULTIPLE-FACTOR MODELS
– FORMULA
ri = ai + bi1 F1 + bi2 F2 +. . .

+ biKF K+ ei
where r is the return on security i
b is the coefficient of the factor
F is the factor
12
e is the error term
FACTOR MODELS

• SECURITY PRICING
FORMULA:
ri = l0 + l1 b1 + l2 b2 +. . .+ lKbK
where
ri = rRF +(d1-rRF )bi1 + (d2- rRF)bi2+ . . .
+(d-rRF)biK
13
FACTOR MODELS

where r is the return on security i


l0 is the risk free rate
b is the factor
e is the error term

14
FACTOR MODELS

• hence
– a stock’s expected return is equal to the risk
free rate plus k risk premiums based on the
stock’s sensitivities to the k factors

15

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